"When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion." - Dale Carnegie, American writerPlease find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards a volatility regime shift.
However, as the BIS recently highlighted, the ratio of loans to corporate bonds has collapsed over the last 20 years in the US. This is why, now that investors have become the main providers of capital to the private sector, it is essential to look at risk appetite/sentiment set of indicators to evaluate that part of the supply dynamic.
On the investors’ sentiment front, the picture is we think quite worrying. The best measure of investors’ risk appetite is high yield corporate credit spreads. They have been widening since last summer in part due to the oil crash, but not only.
If we look at FX volatility, which is another good proxy for risk appetite, it is the same story. FX volatility is, in our opinion, a major input. When it rises, hedging overseas profits becomes more expensive, and overall visibility for global CEOs gets much more blurred.
We have used EURCHF as a risk appetite proxy for a very long time. Back in Q3 2010, we warned that Europe was in a meltdown as evidenced by the massive capital inflows into Switzerland. The EURCHF was crashing and its implied volatility soaring. Six months later, equities were plummeting and risk appetite completely gone.
The MSCI World is flat since July, corporate credit spreads are widening everywhere, commodities and FX volatility have soared since then, and financial conditions have tightened globally as a result.
Retail investors’ sentiment is also important since they hold a lot of corporate debt through mutual funds or ETFs. Their sentiment remains bullish but it is probably the most volatile of all, and one that should be looked at more from a contrarian point of view, especially at extremes like is the case today.
Cash flows are the last variable bloc of our model. To repay debt, a company needs stable to rising cash flows. Earnings thus need to be watched closely. We look at earnings revisions (the one month change on 12mth forecasts) as the best leading indicator for expected cash flow momentum. Negative earnings revisions imply weakening cash flows and inversely.
It is astonishing to realize that today, earnings revisions are the most negative since 2008, and almost equal to the peak level of the 2002 bear market, while US equities have just printed a new historical high. Earnings forecasts are being revised lower at an alarming pace, mostly because of the dollar’s strength but also because capital goods spending are being cut aggressively. In the meantime US equities are being lifted on the back of European and Japanese QE. This tells us that we could be in the very final stages of the equity bull market that started 6 years ago. Complete disconnect between fundamentals (earnings) and prices are a classic signs of a top formation.
The current environment reminds us of 2011 but totally reversed. Back then, US earnings revision were strong, balance sheet were still healthy, and credit availability was large. As a consequence, the VIX fair value was substantially lower than spot level. Fears about the Eurozone sovereign crisis pushed US equity volatility to levels completely unjustified by US fundamentals. In time, the VIX converged towards its fair value. Today, US fundamentals have deteriorated but equities are at historical highs and volatility in the mid 10s. We think that unless earnings estimates are not revised upwards very quickly, a burst of downside volatility will materialize. Between 2009 and 2012, selling equity implied volatility was part of our investment strategy. For the first time in more than 6 years we are now looking to buy it.
While timing a market top can be costly and energy consuming, we are convinced that equity volatility will soon rise very sharply. Equity prices could rotate in a range for a while longer before moving down, but volatility will rise in the process.
Furthermore, the US dollar strength is tightening financial conditions globally. Because cheap dollar funding has infiltrated the corporate world from Moscow to Beijing and Sao Paolo, defaults will inevitably rise together with equity volatility. Implied volatility bottomed exactly when the US dollar started rallying in July 2014. This is because in a world where the stock of dollar credit to non‐banks outside the United States has reached $9.2Trn, to which we should also add sovereign debt in USD, a sharp appreciation of the US currency equals a sharp tightening of financial conditions for non US borrowers. And we know that tighter financial conditions imply increased risks of defaults and hence higher volatility.
All the factors mentioned above (balance sheet leverage, private sector credit growth, credit availability) are even more stretched for Emerging Market equities.
The EM Earnings Revision Ratio is weak.
Private sector credit growth has been buoyant since 2009, dollar denominated debt has spiked, rising at close to 15% every year since 2009. EM corporates balance sheet leverage has significantly risen as a consequence.
The credit channel, as evidenced by the IIF EM lending survey, is tightening domestically. The EM currencies crash vs. the dollar are tightening financial conditions even more. NPLs are on the rise. Rating downgrades are accelerating sharply. In Q4 2014 there were 111 more downgrades than upgrades, up from 26 in Q3. In 2015, there has already been 56 net downgrades.
As downgrades outnumber upgrades, the weakest borrowers are shut from capital access, which exacerbates further the default cycle, which leads to more net downgrades and so on: a classic negative feedback loop.
The situation in China is probably worse than anywhere else. If we had proper data on corporate financing needs, balance sheet leverage and credit availability, the fair value on HSCEI implied vol would be we believe quite elevated. It is also interesting to highlight that all previous housing downturns triggered a spike on volatility. Housing prices are now down 5.5% yoy, and with 69 out of 70 cities registering negative yoy prices, the momentum on the downside is alive.
If we look at EEM, the 12mth implied volatility it is at the 8 percentile so is the 12mth implied ratio with SPX (7 percentile)
EEM, KOSPI and HSCEI implied volatilities are cheap on both an absolute and relative basis.
Stay tuned!"Logic is the technique by which we add conviction to truth.' - Jean de la Bruyere